Applying the Opportunity Zone Program in the Wake of the COVID-19 Pandemic
In December 2019, the Treasury released final regulations for the opportunity zone program (the "Final Regulations") to refine and clarify certain aspects of the first two sets of proposed regulations and to make the rules easier to follow and understand.
The opportunity zone program was created as part of the Tax Cuts and Jobs Act signed into law in December 2017 as a new tax incentive program to spur economic growth and investment in designated distressed communities called opportunity zones ("OZs").
The OZ incentive program allows for the deferral of certain capital gains to the extent such gains are invested in a qualified opportunity fund ("QOF"), but it also allows for income exclusion for gains on investments in QOFs that are held for at least ten years. Those tax benefits available under the OZ program include the following:
- Deferral of taxation on original capital gain reinvested into a QOF, until December 31, 2026 (or earlier, if sold).
- Reduction of capital gains tax (at end of deferral period), by 10% if QOF investment has been held for five years.
- By 15% if QOF investment has been held for seven years (the seven-year window expired on December 31, 2019).
- No taxation on gain from the sale of an investment in a QOF if held for ten years.
- Tax benefits are only for reinvested gain; not for after-tax cash investment.
In light of the unprecedented economic challenges presented by the COVID-19 outbreak, taxpayers with short-term or long-term capital gain income generated in 2019, or in early 2020, can use the OZ program to invest the qualified gains in a QOF for a period of time.
As some investors reevaluate their commitments to qualified opportunity zones ("QOZs") in light of the COVID-19 global pandemic, they may enjoy some level of favorable tax treatment in 2020 if they decide to liquidate their capital from the funds. While investors would likely consider multiple variables before deciding to take money out of OZs (i.e., the extent fund withdrawal is allowed, market stability, and investor ability to write off losses), the Code has some advantages for those seeking to opt out of funds.
To the extent individuals had deferred capital gains by committing them to QOFs in previous tax years, the gains would be recognized in 2020 if those investors decided to liquidate their investment in 2020.
Such liquidation would result in those investors' ability to offset their capital losses generated in 2020, thereby reducing their tax liabilities. While such result may not be the original tax benefit investors were looking for when they invested in opportunity funds, it may be more beneficial than sustaining a capital loss in 2020 because those losses cannot be carried back.
The Final Regulations clarify that individuals would not be subject to interest or other kinds of penalties if they chose to liquidate their investments early. The OZ program was designed to offer tax relief for investments in low-income communities and does not levy interest-laden penalties on investors who choose to withdraw capital gains from funds. The OZ program also allows a restart on the clock on the 180-day window for reinvesting in other funds without losing out on the OZ program's favorable tax treatment.
Once the capital gains have been reinvested into a QOF and then dropped into a qualified opportunity zone business ("QOZB"), taxpayers may have up to 62 months to reinvest the proceeds into various QOZ projects. This extended reinvestment period is particularly useful in light of the uncertainty in the current markets.
Given the market's current volatility, investors may be willing to realize losses in 2020 to offset previously deferred gains. Note that the IRS may challenge attempts to offset gains and losses by liquidating OZ investments to determine if those individuals lacked bona fide, good-faith intentions to follow through on those commitments (in line with the anti-abuse provisions discussed hereinafter).
The Final Regulations became effective March 16. The new rules give taxpayers increased flexibility and an extension of time when it comes to determining when the 180-day capital gain reinvestment countdown begins for purposes of meeting the QOF deadline.
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“Applying the Opportunity Zone Program in the Wake of the COVID-19 Pandemic,” by Michael I. Sanders and Kendra H. Merchant was published in the July/August 2020 edition of the WG&L Journal of Corporate Taxation (Vol. 47, No. 4), a Thomson Reuters publication. Reprinted with permission.